Options: valuation

1. Options: valuation

2. Intro: Individual Equilibrium • Option valuation: What is the equilibrium price for an option? • In essence, we are interested in market equilibrium prices. It is, however, easier to understand from an individual investor’s point of view first. Note: the timing of buying/selling an option contract!!! • Example: Suppose you plan to long/short a European call option on IBM. Payoff Buyer pays C IBM price at T x t=0 t=T Time(t) Payoff Seller gets C IBM price at T x Options? Terminology Arbitrage Binomial Black-Scholes

3. Intro: Individual Equilibrium • You buy/sell in order to acquire a future payoff structure. Your future payoff after you have engaged yourself in a long/short position of the IBM option is now “contingent” on the future IBM’s share price. • Depending on your belief, your portfolio, interest rate, etc., you will have in your mind a price you would be willing to pay/get in order to engage in such a future payoff structure. Payoff Buyer pays C IBM price at T x t=0 t=T Time(t) Payoff Seller gets C IBM price at T x Options? Terminology Arbitrage Binomial Black-Scholes

4. Individual => Market Eqm. • We learnt from CAPM that a market equilibrium must satisfy the following: Every individual investment position is in his equilibrium. • Therefore, market equilibrium essentially involve all individual equilibria. • In option pricing, we carry on the same idea. But we use a short cut to formulate the equilibrium option prices. We employ the concept called, “no arbitrage” Options? Terminology Arbitrage Binomial Black-Scholes

5. Arbitrage • In the last lecture, we have studied the Put-Call Parity. • In fact, it also uses the concept of no arbitrage. • What is arbitrage? • Definition: • “An arbitrage opportunity arises when an investor can construct a zero investment portfolio that will yield a sure profit.” • In general, if the law of one price is violated, arbitrage opportunity emerges. If a product is trading at different prices in two very close locations, you take advantage by buying from the lower-priced location and immediately selling at the higher-priced location. Your profit is equal to the price differential. Again, arbitrage appears because the law of one price is violated. Options? Terminology Arbitrage Binomial Black-Scholes

6. Arbitrage • Imagine the above scenario would induce not only you but other people to jump into it to take advantage of the price differential. It is the fact that so many people are ready to jump on to an arbitrage opportunity that essentially keeps the law of one price holds. Because the increased demand at the lower-priced location will quickly jack up the price, while the increased supply at the higher-priced location will push down the price. This adjustment process goes on until the two prices equalize. • But how are we going to apply the concept to risky assets? • Imagine there are two portfolios each composed of totally different assets. If their future payoffs across EVERY possible future state are EXACTLY the same, the two portfolios should have the same present value. (e.g., if IBM or Bombardier shares offer the exact same payoff structure to investor, their share prices should be the same, regardless of them being different companies. The bottom line: payoff structure, not assets) • What if their prices do differ? There is an arbitrage opportunity. Anyone can construct the lower-cost portfolio. And sell it at a higher price and earn immediate profit. Such forces of trying to take advantage of the mis-price will eliminate the arbitrage opportunity. Options? Terminology Arbitrage Binomial Black-Scholes

7. No Arbitrage: An Example • Similarly put-call parity employs the concept of no arbitrage. A risk-less portfolio should be priced as a risk-less asset. • Payoffs of 3 different assets in each of the 3 possible states • It may not be that obvious, but imagine a portfolio with (2y + 1z) would have a payoff structure exactly the same as if you hold 1x alone. • No arbitrage means, Px = 2Py + Pz • Payoff structure being the same = payoffs at EVERY possible state are the same Options? Terminology Arbitrage Binomial Black-Scholes

8. No Arbitrage: Put-Call Parity • We set up a similar table as the previous slide. Payoffs at expiration date (i.e., Time = T) are listed in the table cells. • Same idea here. A portfolio consisting of the bottom 3 items would have a payoff exactly the same as if you hold the top risk-free investment alone. • No arbitrage means, P2 - P3+ P4 = P1 • Thus, • S0 + P – C = X/(1+Rf)T Options? Terminology Arbitrage Binomial Black-Scholes

9. No Arbitrage: Put-Call Parity $ • The graph of combining different options and assets is such that the payoffs of all assets are added up vertically. <= Long 1 put <= Long 1 stock <= Short 1 call <= Total payoffs ST x ST x ST x x Total Payoff ST x Options? Terminology Arbitrage Binomial Black-Scholes

10. Financial Engineering • One of the many attractions of options is the ability they provide to create investment positions with the resulting payoff structure dependent on a variety of ways on the underlying securities’ prices. $ • Imagine the 4 different payoffs patterns: • Long Put • Long Call • Short Put • Short Call • And imagine options with different exercise prices and expiration dates. • Wisely and creatively combines options and you can build up different types of payoff structure tailored towards your investment needs. <= Long 1 put <= Long 1 call <= Short 1 put <= Short 1 call ST x ST x ST x ST x Options? Terminology Arbitrage Binomial Black-Scholes

11. Option strategies • There are unlimited number of ways for how you combine different options to form a specific payoff structure that you want. • To appreciate the power of using options, you need to be very familiar with the payoff structures of options. • To be a successful financial controller, fund manager, pension fund manager, investment banker, etc., or purely to get the most out of your personal investments, you have to be creative in using options. Options? Terminology Arbitrage Binomial Black-Scholes

12. Strategy: Protective Put • You would like to invest in Google, or you have already invested in Google. However, you are very unwilling to bear potential loss beyond a given level. What you can do is the following: • Invest in the Google stock • Buy one put per share of Google stock • Such an option strategy is called protective put. • The final payoff structure is such that no matter how much Google’s share price drops, your overall loss is limited to a fixed amount, whereas if Google’s share increases in price, you will still benefit. • The exercise price of the put you choose will dictate the maximum loss you are willing to bear. • Again, it is a protective way of holding a stock, that’s why it’s called Protective Put. <= Long 1 stock <= Long 1 put <= Total Payoffs ST x x ST x Total Payoff x ST x Options? Terminology Arbitrage Binomial Black-Scholes

13. Strategy: Covered Call • What if you're neutral on Google’s performance? (i.e., you think its stock price will remain relatively unchanged) To potentially profit from such expectation: • Invest in the Google stock • Sell one call per share of Google stock • Such an option strategy is called covered call. • The final payoff structure is such that no matter how much Google’s share price drops, your overall loss is limited to the price you pay today. And you still have the amount you acquired from selling a call. • If share price increases, and the call holder exercises its right to buy from you, you have a stock to fulfill your obligation. • If share price does not change much, for example, it remains at X on the expiration date, then you’ve gained C, the sales price of the call you sold. <= Long 1 stock <= Short 1 call <= Total Payoffs ST x x ST x x Total Payoff ST x Options? Terminology Arbitrage Binomial Black-Scholes

14. Strategy: Straddle • Imagine another scenario. A pharmaceutical company just release a drug which is soon to be approved or disapproved by the FDA. You anticipate either a big jump of its share price if FDA approves, or a big drop otherwise. To profit from it: • Buy one call of that company’s stock. • Buy one put of that company’s stock • Such an option strategy is called Straddle. • The final payoff structure is such that if that company’s stock price varies a lot, you will benefit the most. • If instead, the company’s stock price doesn’t vary a lot because of the news, you will likely make a loss. <= Long 1 call <= Long 1 put <= Total Payoffs ST x x ST x Total Payoff x ST x Options? Terminology Arbitrage Binomial Black-Scholes

15. Valuation: Option definitions revisited • There are 2 basic types of options: CALLs & PUTs • A CALL option gives the holder the right, but not the obligation • To buyan asset • By a certain date • For a certain price • A PUT option gives the holder the right, but not the obligation • To sellan asset • By a certain date • For a certain price • an asset – underlying asset • Certain date – Maturity date/Expiration date • Certain price – strike price/exercise price Options? Terminology Arbitrage Binomial Black-Scholes

16. Valuation: No arbitrage • We have mentioned that if the law of one price is violated, people will jump into the opportunity and make pure profit out of nothing. • In equilibrium, such opportunity should have been eliminated. • The no arbitrage condition serves as one of the most basic unifying principles in the study of financial markets • An application of that is given out in the previous slides to illustrate the put-call parity. • And we’ll keep on using the no arbitrage condition in order to derive the equilibrium option prices. Options? Terminology Arbitrage Binomial Black-Scholes

17. Range of possible call option values • Let us first look at the boundary for a call option. Assuming the underlying stock doesn’t payout dividend before the call option expires. • First, its value cannot be negative. Because the holder of a call option need not be obligated to exercise it if it is not profitable to do so. C≥0 [1 – lower bound] • Second, its value cannot be higher than the present stock price. Because Stock price – exercise price is the payoff of the call. C≤S0 [2 – Upper bound] • Third, its value cannot be lower than the present stock price minus the present value of the exercise price.C≥S0 - Present value of X or C≥S0 – X/(1+R)T [3 – lower bound] • Reason for [3]: if you compare 2 different portfolios: • {a} buy a stock now at S0 and borrow X/(1+R)T • {b} buy a call option with exercise price X. Options? Terminology Arbitrage Binomial Black-Scholes

18. Range of possible call option values • C≥S0 – X/(1+R)T [3 – lower bound] • Reason for [3]: if you compare 2 different portfolios: • {a} buy a stock now at S0 and borrow X/(1+R)T • {b} buy a call option with exercise price X. • Payoff of {a} at maturity is ST – X (i.e, the stock price at time T - the amount that you have to repay to your lender) NOTE: This payoff can be +ve or –ve! • Payoff of {b} at maturity is either 0 if you don’t exercise, or ST – X if you choose to exercise. • What we see is {b} has a more favorable payoff structure than that of {a}, if constructing {a} requires S0 – X/(1+R)T amount of money, than to construct {b}, you need at least more than that amount. • Thus we have the lower bound of the value of call as C≥S0 – X/(1+R)T Options? Terminology Arbitrage Binomial Black-Scholes

19. Range of possible call option values • C≥0 [1 – lower bound] • C≤S0 [2 – Upper bound] • C≥S0 – X/(1+R)T [3 – lower bound] • With all 3 boundary conditions, we get the following graph: Call Value (C) Upper bound = S0 Lower Bound = S0 - X/(1+R)T S0 X/(1+R)T Options? Terminology Arbitrage Binomial Black-Scholes

20. Call option value as a function of stock price • The value of call as a function of the current stock price is given in the following red line. Call Value (C) Upper bound = S0 Lower Bound = S0 - X/(1+R)T S0 X/(1+R)T Options? Terminology Arbitrage Binomial Black-Scholes

21. Factors affecting the call option value • We identify 5 factors that affect an option’s value • 1) Stock price (S) • 2) Exercise Price (X) • 3) Volatility of the underlying stock price (σ) • 4) Time to Maturity/expiration (T) • 5) Interest rate (Rf) • You should familiarize yourself with the following table: FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

22. Factors affecting the call option value • Stock price • Recall the payoff for call and put. Call: max{0,S-X}, Put: max{0, X-S} • The higher the stock price, the more likely that a call option will be exercised in-the-money to get profit. Thus C ↑ if S0↑ • The higher the stock price, the less likely that a put option will be exercised in-the-money to get profit. Thus P ↓ if S0↑ FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

23. Factors affecting the call option value • Exercise price • Recall the payoff for call and put. Call: max{0,S-X}, Put: max{0, X-S} • The higher the exercise price, the less likely that a call option will be exercised in-the-money to get profit. Thus C ↓if X ↑ • The higher the exercise price, the more likely that a put option will be exercised in-the-money to get profit. Thus P ↑ if X ↑ FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

24. Factors affecting the call option value • Volatility of stock price • Recall the payoff for call and put. Call: max{0,S-X}, Put: max{0, X-S} • The higher the volatility of stock price, the higher the probability of S being higher than X and thus the more likely the call will be exercised in-the-money to get profit. Thus C ↑if σ↑ • Surprisingly, it is also true for put. The higher the volatility of stock price, the higher the probability of S being lower than X and thus the more likely the put will be exercised in-the-money to get profit. Thus P ↑if σ ↑ FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

25. Factors affecting the call option value • Time to expiration • Recall the payoff for call and put. Call: max{0,S-X}, Put: max{0, X-S} • The longer the time to expiration, the more time allowed for the stock price to climb above the exercise price and thus the more likely the call will be exercised in-the-money to get profit. Thus C ↑if T ↑ • Surprisingly, it is also true for put. The longer the time to expiration, the more time allowed for the stock price to fall below the exercise price and thus the more likely the put will be exercised in-the-money to get profit. Thus P ↑if T ↑ FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

26. Factors affecting the call option value • Interest rate (risk-free) - the least intuitive • Recall the put-call parity. S0 + P – C = X/(1+Rf)T • Keeping every other variables fixed, the higher the interest rate, the smaller the RHS, and thus C has to increase to lower the LHS too. Thus C ↑if Rf↑ • Keeping every other variables fixed, the higher the interest rate, the smaller the RHS, and thus P has to decrease to lower the LHS too. Thus P ↓if Rf ↑ FactorEffect on Call valueEffect on Put value Stock price increases decreases Exercise price decreases increases Volatility of stock price increases increases Time to expiration increases increases Interest rate increases decreases Options? Terminology Arbitrage Binomial Black-Scholes

27. Binomial option pricing • With all the insights you have acquired. Let’s go to the first formal option pricing model. • Assumption: The stock price can take only 2 possible values on the date the option expires, no transaction cost and imperfections, frictionless market. • An example to illustrate, Binomial option pricing concerns about call options. Let’s now consider a call, with exercise price = $125. Stock price is now $100. At expiration, it will either go up to $200 or down to $50. (Note: NO probability is given) $200 $200 - $125 = $75 $100 C $50 $0 Stock price Call option value • Consider a portfolio that consists of short 1 option and long m shares of this stock. • Payoff of this portfolio is: • Either [Good state] $200m - $75 if the stock price rises to $200 • or [Bad state] $50m if the stock price drops to $50. Options? Terminology Arbitrage Binomial Black-Scholes

28. Binomial option pricing $200m -$75 $200m-$75 $100m -C $100m-C $50m $0 $50m Long m Stocks + Short 1 Call = The combined portfolio • Choose a specific m* to make the combined portfolio risk-less. (i.e., payoffs are the same in both states) • Set $200m - $75 = $50m, solving, we have m* = 75/150 = 0.5 • The ratio is what we needed. That means, if a portfolio consists of longing 1/2 share of the stock and shorting 1 call option, or if a portfolio consists of longing 1 shares of the stock and shorting 2 call options, the portfolio is risk-less. $200m*-$75 = $25 $100m*-C = $50 - C $50m* = $25 The combined portfolio with m* Options? Terminology Arbitrage Binomial Black-Scholes

29. Binomial option pricing $200m*-$75 = $25 $100m*-C=$50 - C $50m* = $25 The combined portfolio with m* • So, the combined portfolio gives me $25 no matter which state is realized; i.e, the portfolio is risk-less. The present value of this $25 at maturity should be equal to the value of the combined portfolio that you pay now (i.e., no arbitrage condition). Thus: • 100m* - C = $50 – C = 25/(1+Rf)T • If time to expiration = 1 year, annual risk-free interest rate = 8%, then the Call option should have a value equal to: • C = $50- 25 /(1+8%)1 = $26.85 (round up 2 significant decimal places) • Using the put-call parity, we can find the put option value with the same exercise price and expiration date. [DO IT YOURSELF!!!] Options? Terminology Arbitrage Binomial Black-Scholes

30. Black-Scholes option pricing formula • Generalizing the binomial option pricing, we have the Black-Scholes formula, which is the Nobel prize winner Prof. Scholes’ main contribution leading to his 1997 Nobel prize. • Black-Scholes formula: • C = S0N(d1) – X•e-RfT•N(d2) • Where d1 = [ln(S0/X) + (Rf + σ2/2)T] / σ√T • And d2 = d1 - σ√T C = Call Option Price S0 = Current Stock Price N(d1) = Cumulative normal density function of (d1) X = Strike or Exercise price N(d2) = Cumulative normal density function of (d2) Rf = discount rate (risk free rate) T = time to maturity of option (as % of year) σ = volatility or annualized standard deviation of daily stock returns Options? Terminology Arbitrage Binomial Black-Scholes

31. Black-Scholes option pricing forumla C = S0N(d1) – X•e-RfT•N(d2) Where d1 = [ln(S0/X) + (Rf + σ2/2)T] / σ√T And d2 = d1 - σ√T N(d1)= cumulative area below d1 for a standard normal distribution. Standard Normal Density Function ~ N(0,1) -0.5 –0.2 0 0.2 0.5 If d1 = 0, N(d1) = 0.50 If d1 = 0.5, N(d1) = 0.69 Options? Terminology Arbitrage Binomial Black-Scholes

32. Black-Scholes option pricing forumla • Some of the important assumptions are as follows: • 1) The stock will pay no dividends until after the option expiration date. • 2) Both the interest rate and the standard deviation of daily return on the stock are constant. • 3) Stock prices are continuous, meaning that sudden extreme jumps such as those in the aftermath of an announcement of a take-over attempt are ruled out. • C = S0N(d1) – X•e-RfT•N(d2) • Where d1 = [ln(S0/X) + (Rf + σ2/2)T] / σ√T • And d2 = d1 - σ√T Options? Terminology Arbitrage Binomial Black-Scholes

33. Black-Scholes: An example C = S0N(d1) – X•e-RfT•N(d2) Where d1 = [ln(S0/X) + (Rf + σ2/2)T] / σ√T And d2 = d1 - σ√T Example What is the price of a call option given the following? S0 = 30, Rf = 5%, σ2 = 0.0305, X = $30, T = 1 year d1 = 0.37362 N(d1) = 0.645657 d2 = 0.198978 N(d2) = 0.57886 C= S0[N(d1)] – Xe-rt[N(d2)] C= $ 2.85, using put-call parity, we can calculate the corresponding put option price. Options? Terminology Arbitrage Binomial Black-Scholes

34. Some more insights on options • American Options can be exercised at anytime before maturity • European Options can be exercised at maturity • It is never optimal to exercise an American call option early: Thus, American and European calls should have the same price • But it may be optimal to exercise an American put option earlier than maturity • Empirical evidence: • Black-Scholes option pricing model does well at pricing options that are at the money, but do much worse as the options go deeper into or out of the money Options? Terminology Arbitrage Binomial Black-Scholes

35. For Final • You will not need to remember the Black-Scholes formula. • You have to try the Black-Scholes formula before the exam because the final exam will for sure have a question concerning the Black-Scholes. That means you have to know how to use a Cumulative normal distribution table. • You have to be familiar with the put-call parity and no arbitrage condition. • You have to know the Binomial option pricing too. Work it out at least once. • You should try to get yourself familiar with how to quote an option price from CBOE. And you should be able to understand the meaning of a table you see from a CBOE option quote. • I strongly encourage you to do the exercises on options posted on the course webpage. Try them before you look into the solutions. Options? Terminology Arbitrage Binomial Black-Scholes